Material Matters: China, Iron Ore, Copper, Lithium, Gold & Coal

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Property weighs on Chinese growth, Citi's outlook for selected commodities; supportive outlook for gold & likely upside risk for coal.

-Structural property shift weighs on China’s trend growth 
-Citi’s outlook for iron ore, copper and lithium
-Supportive backdrop for gold on a weaker US dollar
-Asymmetrical upside risk for met and thermal coal prices

By Mark Woodruff 

Structural property shift weighs on China’s trend growth 

The speed at which China’s growth has declined has even surprised Capital Economics, which has long been more cautious than most on the country’s medium-term prospects.

The rate of trend growth has dropped to 3%, on Capital’s reckoning, down from 5% in 2019, with the main cause a structural shift in the property sector.

Given worsening demographics and lower productivity growth, which the government is unlikely to reform by adopting necessary reforms, Capital expects the deceleration has further to run.

Despite official (and inflated) GDP data being consistent with 4.5% trend growth, the true level is probably closer to 3%, and, as most of the slowdown since the start of the pandemic is structural in nature, Capital suggests it won’t be reversed in a sustainable way by policy stimulus.

Housing demand in China is in the early stages of a protracted structural decline due to the impact of demographics and a slower rural-to-urban migration.

But the news is not all bad. 

The situation for China is like that experienced by Japan when residential investment declined by over -40% from its 1996 peak, yet ongoing growth in real estate services provided an offset over the following (near) three decades.

Nonetheless, as the Chinese government is limiting the ability of developers to cut prices, the outcome may be more severe in China compared to the past in Japan, as demand is being shifted to the secondary market, exacerbating the decline in new home sales and construction, explains Capital.

Real estate activity has been contracting since the end of 2021, notes Capital, even as the rest of the economy has continued to gain ground.

In casting around for reasons other than the property sector for China’s declining trend rate of growth, Capital notes underutilisation of labour doesn’t appear to be a problem, given hours worked are only slightly below peak levels for more than two decades.

Capital Economics.concludes over the next two years, it is looking increasingly like a stagnant property sector is the best policymakers can hope for.

Citi’s outlook for iron ore, copper and lithium

The iron ore price has declined after a July contraction in property sales in China and the lack of hoped-for stimulus after the recent Politburo meeting.

Last week, the SGX TSI iron ore contract, the most active contact in Singapore, fell below US$100/t.

Now, Citi suggests there may be an even bigger risk to iron ore resulting from growing concerns over China’s policy on steel cuts.

Recently, the local government in Yunnan (a relatively small producer) issued a flat growth notice for crude steel production. Of greater importance, suggests Citi, will be upcoming policy clarifications from other major steel production regions, such as Hebei and Jiangsu.

In the meantime, the broker expects prices to fluctuate around US$100/t in the very short term, with risk of a further fall once steel cuts are implemented.

The demand/price for raw materials should come under pressure via these government mandatory steel cuts or from involuntary cuts at mills stemming from weak steel margins, in the opinion of the analysts.

After steel cuts gets under way, Citi expect improvements in steel margins and prefers exposure to hot-rolled coil (HRC) on further pullbacks.

The broker remains cautious on the metals outlook for the rest of 2023 as weakening developing markets growth outweighs stronger Chinese growth in the second half.

On the copper front, Citi notes consumption continues to defy weakness in indicators signalling globally soft manufacturing, thanks to resilience in decarbonisation and certain cyclical sectors. However, investors went long on the metal in anticipation of a major policy easing at the China Politburo meeting, so positions may need to be unwound, potentially weighing on the price.

Besides, such policy measures are unlikely to generate a turnaround in the broker’s view.

It’s felt there may be upcoming medium-term buying opportunities for copper when further policy disappointment collides with existing long market positions, potentially leading to a broader selloff across metals.

Regarding lithium, Citi notes the resumption of the downward trend after prices held flat in July.

The broker lowers its 0–3-month China lithium carbonate price estimate to US$34k/t from US$36k/t, and for hydroxide to US$35k/t from US$38k/t and retains its short-term neutral-to-bearish stance due to supply headwinds.

While short-term electric vehicle (EV) sentiment remains mixed with inventories of EVs piling up across US and Europe, Citi remains positive on the global EV and battery technology thematic.

Supportive backdrop for gold on a weaker US dollar

Decade-to-decade for the past 50 years, gold has tended to hold its relative value and proved an effective hedge in the high inflation period of the 1970s and early 80s, when the gold price appreciated more than ten-fold in less than a decade.

Over this period, Wilsons notes the inflation problem was structural and took a long time to bring under control. The lack of a gold price spike in 2021/22 is attributed to the market’s view at the time of inflation’s transitory nature.

The gold price has also demonstrated a long-term negative correlation with the US dollar, which is not readily apparent when looking at month-to-month or year-to-year fluctuations, points out the broker, particularly as both assets are viewed as havens in times of market turmoil.

As extended interest rate easing cycles tend to correlate with a weaker US dollar, there is a supportive cyclical backdrop for the gold price, according to Wilsons, given the likelihood of a 2024 easing cycle in the US.

If equities are going to disappoint in the coming year, there is a greater chance this will be due to disinflationary growth rather than inflation upside pressure, suggests Wilsons, which should in turn result in a significant easing of interest rates.

The ideal for the gold price, which corresponds with the broker’s view, is for an orderly deceleration in growth so the US dollar is not regarded by the market as a haven.

In short, Wilsons maintains its moderate exposure to physical gold via exchange traded funds and is hedged on currency as the Australian dollar is considered undervalued at present.

Asymmetrical upside risk for met and thermal coal prices

Morgans reduces its forecasts for the coal sector due to lower estimates for coal prices and higher longer-term costs.

Longer-term pricing risks to realised pricing are, however, asymmetrically skewed to the upside for both metallurgical (met) and thermal markets given worsening structural impediments to supply, explains the broker.

While share prices have stabilised, the analyst expects a soft near-term outlook for coal prices, particularly for steel/met coal, and lowers its FY24-25, forecasts for NEWC (thermal prices) and hot coking coal (HCC) by -25-35% and -0-3%, respectively.

The NEWC Index prices have stabilised in a US$130-140/t trading range since June. While this level represents a -US$300/t fall from the late 2022 peak, Morgans reminds investors it still represents a healthy US$20/t premium to the ten-year average NEWC price and is stronger again in Australian dollar terms.

As equity valuations are so depressed and "short-sightedly" imply coal markets will never again tighten to support windfall cash flows, Morgans retains its Add rating for coal shares under its coverage, except for New Hope ((NHC)) which is downgraded to Hold after share price outperformance relative to peers in 2023.

The broker’s 12-month target prices for New Hope, Whitehaven Coal ((WHC)), Coronado Global Resources ((CRN)) and Stanmore Resources ((SMR)) are all reduced significantly.

The analyst sees potential for both Stanmore and Coronado to exit the sale process for the auction of BHP Group's ((BHP)) Daunia/Blackwater coal assets, which Morgans believes should unwind current valuation discounts being applied by the market.

Moreover, both companies have recently sanctioned new internal growth projects, representing very low capital intensity options to unlock incremental production, points out the broker.

The Curragh North underground development by Coronado lifts group met production by 15% while notionally lowering group costs, while Stanmore’s South Walker Creek expansion lifts group production by around 10% and has competitive costs, explains the analyst.

Whitehaven is also in the mix for the BHP assets and its shares are trading at a discount. Despite having several bidding advantages over Stanmore and Coronado, including superior funding, the broker observes shareholders appear to favour returns compared to growth.

If management stays involved in the process, the broker suggests the valuation discount may widen not only due to deal risk, but also aversion to the possibility of dividend deferral and re-gearing.

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